Most people in America have some kind of debt. I don’t know why, but these days, it seems to be rampant. Keep in mind that debt can be in the form of a mortgage, a car loan, a student loan, credit card balances, etc. Basically, anything that you have borrowed money for is considered debt. Having debt can be good for you as long as you don’t overdo it and are diligently working to pay it off.
Let me stop here for a minute and clarify things a bit. I think I just lost a few people here because they’ve been told that debt is evil and you should never have it. Well, that’s completely wrong. Having debt allows you to build an established payment history. This history allows companies to see how responsible you’ve been with your debt payments. If you’ve done a good job at keeping up with your payments and not just paying the minimums then you’ve probably built yourself a really good credit rating. This credit history is very important and will allow you to buy a car, a house, or other items using credit.
Calculate Your Debt Ratio
What is a debt ratio and how do you calculate it? In layman’s terms a debt ratio is the process in which you compare how much you make, also known as income, with how much you’re spending (i.e. debt).
This isn’t complicated at all and is very easy to do. What you want to do is add up all your monthly payments such as credit cards, car loans, bank loans, etc. Everything that has a payment due date and can be reported to a credit agency needs to be included in this list.
Then add up all your income sources, such as paychecks, alimony, or any other money that you receive on a monthly basis.
Now that you have your monthly debt and income calculated, you divide your total monthly debt by your total monthly income calculated above. Multiply this number times 100 to get your debt to income ratio. This process is the same one that banks used to determine your credit worthiness.
What is a Good Debt to Income Ratio?
When it comes to debt, the lower your overall debt ratio is the better. Now there are two types of debt, good and bad.
On the other hand, bad debt is considered anything that you finance which is just consumed and does not appreciate and value. This kind of debt is what creates a bad financial situation. Credit should never be used to purchase everyday items such as food, clothes, gas, etc.
Here’s the caveat, if you’re very diligent about paying off your credit cards every single month so that you have zero balance, then it is okay to use your credit cards to buy food, clothes, and any other regular expense. A good debt to income ratio for bad debt ratio should be less than 10% of your monthly income.
Your total debt to income ratio, when looking at that and good debt together, should be 36% or lower. Anything higher than 36% is considered to be risky for creditors and a ratio over 40% is considered to be a potential financial disaster.
If after reading this you determine that you have way too much debt, it’s not the end of the world. You can still change your situation by putting a plan together and paying it down. When paying down your debt make sure that you focus on your bad debt first. Once you have paid down your debt, it will give you some additional money and will also make managing your finances easier. The second thing it will do is improve your credit score.
Do you have too much debt?
Good post. I think too often as pf bloggers we tend to think debt is bad, no matter the type. There can be good debt…if it’s allowing to to increase your income, have a house that appreciates, etc. I think the key is finding a balance and using debt to your advantage.
Hello John S. I don’t think is limited to just PF bloggers and I find that a lot of people just think debt is all bad. The main reason for this is due to people not really understanding what that really is and how to use it to their advantage. As you mentioned a key point is to make sure that you maintain a good balance with your debt to income ratio. The matter how much good that you have, there’s still a potential of having too much debt and getting you into a bad situation.
It’s funny that in all the PF blogs, I have yet to come across one that simply asks if you have too much debt, and then gives a little math equation to figure that out. Thanks! Simple and easy!
Thanks for the comment TB. I noticed the same thing, so I figured I’d cut to the chase and show people how easy it is to determine if they have too much debt. Hope this information helps you out
I have zero credit card or consumer debt, and a high ratio of “good debt”. But since I have some equity, I actually just consider that equity as my own. I don’t think that I own a house and owe a mortgage, just that I have that equity cushion on my investment, there is no debt burden.
Thanks for the comment. You different on the right track Pauline and I do the very same thing. Since I own a home and pay my mortgage on time and more than the minimum, I too am not worried about the debt burden because my home equity is almost as much as I owe.
Amy, you made it so easy to figure out whether we have too much bad debt, that’s not something I’ve seen across the blogs I’m currently reading. One question: do you subtract the “good debt” from total monthly debt or does that have to be part of the calculation?
That’s a good question Veronica. I’m glad you brought it up. Bankers look at this stuff a couple different ways, with the first being what is your what is your bad debt to income ratio. This gives them a good idea as to your financial status. If they see your bad debt to income ratio being less than 10%, they continue on to the next phase their analysis. The next step in the analysis is to look at your whole financial situation which shows shows how much your overall debt to income ratio is. This is where you add up you good and bad debt and divide by your monthly income. The point of this is to really break down and see where you debt really really is.
You need to look at both your overall debt income ratio as well as your bad debt to income ratio in order to understand your overall financial health.
Thanks for clearing that up!
“A good debt to income ratio for bad debt ratio should be less than 10% of your monthly income.” How I would KILL to have a debt to income ratio of 10% or less….I honestly can’t even imagine having that low of a ratio….
She probably meant “a great debt to income ratio should is around 10%” because right below it she stated: “Your total debt to income ratio, when looking at that and good debt together, should be 36% or lower.” I can certainly see people at 36% but 10% seems extremely difficult, doesn’t it? Unless you’re a Newport millionaire lol!
Honestly, the saying that you can’t make money without spending money is true. I guess you could save everything you make, but I really think purchasing a home and investment property is a great debt to have if you are smart about what you buy and have enought of a down payment so that you have some equity if the market goes down. Like you said, debt that makes money for you isn’t always bad.
That’s very true Kim, it does take money to make money. If you did save everything you made, you’d have a decent savings, but the key is to make your savings work for you. If you leave it in a bank that pays less than 2% it’s not growing at all. That’s why it’s really important to purchase a home to help shelter your savings. The other thing that people tend to forget is that there are a lot of benefits of buying a house. The first as you mentioned is it’s an investment that will grow overtime. Another benefit is that you get to deduct any interest paid on you home loans on your taxes. This can be a substantial savings and a source of a nice refund check from the IRS.
I like the idea of concentrating on debt ratios instead of just the total debt. Given how much incomes vary, the total debt is actually quite irrelevant… Good Post!
Thanks Scot. I think that using debt ratios really helps people understand where they are with their finances. If you just look at your total debt, it can be very difficult to see, if and where there are problems.
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I’m of the opinion that > $0 debt is too much. I can’t wait until I am out of debt and I will try my hardest to get out of it.
Good point with the credit cards, they can be really helpful and good to use provided you pay them back on time.
Glen, I was of the same mind many years ago. I know it sounds great to be debt free and that’s a great goal to have, but before you think that way you really need to understand how to make the money work for you and not take money out of investments to purchase things. Instead, you use low cost and no cost loans to fund those purchases.
Credit cards are great and can work for you if used properly and as you mentioned, the key is to never carry a balance.
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Our debt ratio isn’t terrible in terms of monthly payments, but I still like to glare at my monthly student loan payment. Brian was able to pay his off quite quickly by taking a second job, but I am still stuck with mine. I’m hoping to pay it off in the next few years now and then our debt ratio will start looking a bit more favourable!